Fixed income investors should look to Corporate High Yield bonds, Emerging Market Debt (EMD) and Alternative Credit as potential solutions to counter rising interest rates when Western governments normalise their monetary policies, says Pieter Jansen, Senior Strategist at NN Investment Partners, who believe these assets offer investors attractive returns in either of the two economic scenarios going forwards.

Scenario 1 entails global growth breaking through the 3.5% level that has acted like a ceiling over the last six years.

Scenario 2 involves the continuation of a rangebound economy. Read more about these possible scenarios here.

Jansen outlines the reasons for each asset class’s attractiveness: “Higher global growth would create an environment in which investors would be tempted to move into equity-like assets. Given that High Yield tends to have the highest positive correlation to equities among the Fixed Income classes, it would likely become a preferred investment class in our first scenario”.

“EMD is likely to perform well from a total return perspective in low or higher economic growth,” he adds, “but it should do particularly well in our second scenario, due to investors seeking yield, their attractive valuations and the moderate US Treasury yield increases that could be expected”.

Within Emerging Markets (EM), Frontier Market Debt (FMD) denominated in hard currencies (HC) offers investors higher yields and shorter durations than the more mainstream EMD, according to Jansen. He believes, “With a higher spread cushion and low historical correlation with US Treasuries, FMD could outperform other fixed income asset classes, especially if commodity prices are on a stable or increasing path”.

In Jansen’s opinion, higher-yielding EM local currency debt could also benefit in a search-for-yield environment: “These currencies are undervalued on a trade-weighted basis and capital flows to EMs are currently robust. If global growth picks up, EM currencies are likely to strengthen”.

“For Alternative Credit strategies, a key factor is whether the coupons are fixed or floating. The floating rate strategies such as Export Credit Agency, Commercial Real Estate and EM credit benefit from a rise in interest rates in both of our scenarios, but especially the first”.

“Alternative Credit is an attractive option for investors in various market conditions. If growth is range-bound, the low-yield environment would still drive investors towards the less liquid loans to capture the illiquidity premium. Rising interest rates can make loan strategies with floating rate coupons particularly interesting as they benefit from increases in EURIBOR or LIBOR. Commercial Real Estate Loans, Export Credit Agency Loans and Emerging Market Loans are examples of such asset classes. The benefits of these would be even more pronounced in scenario one”.

Jansen concludes: “A rising yield environment is a challenge for investors. However, fixed income continues to be an important element of a diversified portfolio. Investors have to be more selective with how they tilt their fixed income exposure. In both scenarios, we see more potential within the specialised Fixed Income universe, outside the traditional world of ‘safe’ long-duration assets. Illiquid assets can benefit in either scenario, but it is important to evaluate specific characteristics of the asset classes. In general, scenario one shows that rising government bond yields are not necessarily a negative for all Fixed Income. What it also shows is that investors can no longer ride the ‘search for yield’ train. They need to become more selective and find flexible solutions using asset classes that are less sensitive to duration and have adequate growth potential. Frontier Market Debt (FMD) is a good example”.